Chapter Eight

Regulation and Ethics

1. Introduction 147

2. Financial Crime 150

3. Insider Trading and Market Abuse 153

4. Integrity and Ethics in Professional Practice 156

This syllabus area will provide approximately 5 of the 50 examination questions

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 Regulation and Ethics

1. Introduction
An understanding of regulation is essential in today’s investment world. In this chapter, we will aim to
take an overview of regulation by looking at it in an international context, before looking at the essential
role of integrity and ethics in the financial services sector.

1.1 The Need for Regulation

Learning Objective
8.1.1 Understand the need for regulation and authorisation of firms

The risk of losing money that can arise from many types of financial transactions has meant that financial
markets have always been subject to the need for rules and codes of conduct to protect investors and
the general public, although these rules have not always been in place or enforced as robustly as they
are today.

As markets developed, there grew a need for market participants to be able to set rules so that there
were agreed standards of behaviour and to provide a mechanism so that disputes could be settled

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readily. This need developed into what is known as self-regulation, when, for example, as well as fulfilling
its main function of providing a secondary market for shares, a stock exchange would also set rules for its
members and police their implementation.

With the development of global financial markets came the need for improved and common standards,
as well as inter­national cooperation. Self-regulation became increasingly untenable and most countries
moved to a statutory approach (that is, with rules laid down by law so that breaking them is a criminal
offence). They also established their own, independent regulatory bodies. The need for international
cooperation between regulatory bodies also led to the creation of an international organisation, the
International Organization of Securities Commissions (IOSCO).

IOSCO designs objectives and standards that are used by the world’s regulators as international
benchmarks for all securities markets. These objectives and standards can be seen in most systems
of securities regulation. Today, there is a significant level of cooperation between financial services
regulators worldwide and, increasingly, they are imposing common standards. Anti-money laundering
(AML) rules are probably the best example.

Effective capital and financial markets are an essential part of developed and developing economies.
They fuel economic development and aid wealth creation. Confidence and trust in these markets are
vital ingredients. Loss of confidence and trust can result in the failure of financial companies and have
an adverse impact on the economy. This, in turn, may lead to a reduction in employment prospects and
severe hardship.

As a result, countries set laws and regulations to manage the framework within which financial services
businesses and individuals can operate. Different approaches are adopted, such as rules-based systems,
principles-based systems and self-regulation, but there is a common theme through these of the need

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for some form of authorisation of firms that wish to operate in the industry. Regulatory bodies set
minimum standards for market participants both for their initial authorisation and their continued
operation. The authorisation process normally requires a comprehensive assessment of the applicant
to ensure that they are ‘fit and proper’ and covers areas such as their intended activities, the financial
position of the firm and the suitability of its senior management.

In summary, the objectives and benefits of regulation can be viewed as the following:

• It increases the confidence and trust in financial markets, systems and products.
• It helps establish an environment that encourages economic development and wealth creation.
• It reduces the risk of market and system failures (along with the economic consequences of such
failures).
• Consumers are better protected, giving them the reassurance they need to save and invest.
• Financial crime is reduced, if the financial systems are not an ‘easy target’ for criminals to exploit.

1.1.1 Authorisation
Financial regulation in a country will usually make it an offence for a firm to provide financial services
without being authorised to do so.

Authorisation is granted by the relevant regulator depending on the financial services sector that a firm
operates in. The regulator(s) looks at each applicant to assess whether the firm is fit and proper and
meets certain threshold conditions. Before granting authorisation, the regulator would usually consider
factors such as the company’s management, its financial strength and the calibre of its staff. The latter
is particularly important in certain key roles, which the regulator (in some jurisdictions) classes as senior
management functions (SMFs) or certain other key functions.

By only allowing fit and proper firms to be involved in the financial services sector, the regulator begins
to satisfy the objectives of enhancing financial stability, enhancing the integrity of the financial system
and protecting consumers.

1.2 Regulatory Principles

Learning Objective
8.1.2 Understand the main aims and activities of financial services regulators

Governments are responsible for setting the role of regulators and in so doing will clearly look to
see that international best practice is adopted through the implementation of IOSCO objectives and
principles and by cooperation with other international regulators and supervisors.

As an example of this, European governments cooperate regionally to ensure there is a framework of

regulation that encourages the cross-border provision of financial services across Europe by standardising
or harmonising each country’s respective approach. European regulators cooperate to coordinate activities
and draft the detailed rules needed to introduce pan-European regulation through the European Securities
and Markets Authority (ESMA).

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 Regulation and Ethics

In Asia, the basic structure and content of securities regulation is increasingly similar to the model
adopted in most other parts of the world. Most countries are members of IOSCO and subscribe to its
principles of securities regulation. It is similar in the Middle East where regulators have looked to take
examples of best regulatory practice from countries such as the UK and Australia and have then adapted
them to their local markets.

Regulators will typically be given a set of objectives by governments; a summarised example of these
from a variety of regulators is shown in the following table. The main purposes and aims of regulation,
in all markets globally, are to:

• maintain and promote fairness, efficiency, competitiveness, transparency and orderliness

• promote understanding by the public of the operation and functioning of the financial services
sector
• provide protection for members of the public investing in or holding financial products
• minimise crime and misconduct in the industry
• reduce systemic risks, and
• assist in maintaining the market’s financial stability by taking appropriate steps.

In order to achieve the main objectives of financial regulation, regulators worldwide have developed a
series of codes of conduct that are used to set standards for businesses and individuals. Later, in section
4.1, we will consider the Code of Conduct issued by the Chartered Institute for Securities & Investment
(CISI) as an example of how professional bodies also have a role to play in setting acceptable standards

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of behaviour.

UK – Prudential
US – Securities and Dubai Financial Chinese Securities
Regulation Authority
Exchange Commission Services Authority Regulatory
(PRA) and Financial
(SEC) (DFSA) Commission (CSRC)
Conduct Authority (FCA)

Promote the safety and

soundness of firms,
Foster and enforce Maintain fairness, Supervision of
focusing on the harm
compliance with the transparency and securities and
that firms can cause
federal securities laws efficiency futures markets
to the stability of the
financial system
Increase ability
Establish an Secure an appropriate Maintain confidence
to handle and
effective regulatory degree of protection for in the financial
prevent financial
environment consumers sector
crises
Facilitate access to the
Promote efficiency and Maintain financial Prepare
information investors
choice in the market for stability and reduce regulations for
need to make informed
financial services systemic risk securities markets
investment decisions

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 UK – Prudential
US – Securities and Dubai Financial Chinese Securities
Regulation Authority
Exchange Commission Services Authority Regulatory
(PRA) and Financial
(SEC) (DFSA) Commission (CSRC)
Conduct Authority (FCA)

Enhance SEC
performance through Prevent conduct Exercise
Protect and enhance
effective alignment that damages the supervision
the integrity of the
and management of financial services of securities
financial system
human, information, sector businesses
and financial capital
Promote public
Investigate and
understanding and
penalise violations
protect users of
of securities laws
financial services

2. Financial Crime

2.1 Money Laundering

Learning Objective
8.2.1 Know what money laundering is, the stages involved and the related criminal offences
8.2.2 Know how firms/individuals can be exploited as vehicles for financial crime: fraud; cybercrime;
terrorist financing

Money laundering is the process of turning money that is derived from criminal activities – dirty money
– into money which appears to have been legitimately acquired and which can, therefore, be more
easily invested and spent – clean money.

Money laundering can take many forms, including:

• turning money acquired through criminal activity into clean money

• handling the proceeds of crimes such as theft, fraud and tax evasion
• handling stolen goods
• being directly involved with, or facilitating, the laundering of any criminal or terrorist property, or
• criminals investing the proceeds of their crimes in the whole range of financial products.

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 Regulation and Ethics

Examples include the following:

• The Financial Action Task Force (FATF), which has issued recommendations aimed at setting
minimum standards for action in different countries to ensure AML efforts are consistent
internationally. It has also issued special recommendations on terrorist financing.
• Standards issued by international bodies to encourage due diligence procedures to be followed for
customer identification.
• Sanctions by the United Nations (UN) to deny access to the financial services sector to individuals
and organisations from certain countries.
• Guidance issued by the private sector Wolfsberg Group of banks in relation to private banking,
correspondent banking and other activities and similar guidance issued by other trade bodies.

2.1.1 Stages of Money Laundering

There are three stages to a successful money laundering operation:

• Placement is the first stage and typically involves placing the criminally derived cash into an
account with a bank or other financial institution.
• Layering is the second stage and involves moving the money around in order to make it difficult for
the authorities to link the placed funds with the ultimate beneficiary of the money. Disguising the
original source of the funds might involve buying and selling foreign currencies, shares or bonds.

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• Integration is the third and final stage. At this stage, the layering has been successful and the
ultimate beneficiary appears to be holding legitimate funds (clean money rather than dirty money).
The money is integrated back into the financial system and dealt with as if it were legitimate.

Broadly, the AML provisions are aimed at identifying suspicious activity, including through familiarity
with customers, and through reporting suspicions at the placement and layering stages.

In addition, firms are required to keep adequate records so that an audit trail can be established if the
need arises.

2.1.2 Terrorist Financing

There can be considerable similarities between the movement of terrorist funds and the laundering
of criminal property. Because terrorist groups can have links with other criminal activities, there is
inevitably some overlap between AML provisions and the rules designed to prevent the financing of
terrorist acts. However, these are two major differences to note between terrorist financing and other
money laundering activities:

• Often, only quite small sums of money are required to commit terrorist acts, making identification
and tracking more difficult.
• If legitimate funds are used to fund terrorist activities, it is difficult to identify when the funds
become terrorist funds.

Terrorist organisations can, however, require significant funding, and will employ modern techniques
to manage the funds and transfer them between jurisdictions, hence the similarities with money
laundering.

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2.2 Other Areas of Financial Crime
Individuals and firms may unwittingly find themselves targeted by criminals and have to be aware
of this possibility, and areas that staff working in financial services need to be aware of is the theft of
customer data to facilitate identity fraud and cybercrime.

Identity fraud or identity theft is one of the fastest-growing types of fraud in the UK.

• Identity fraud is the use of a misappropriated identity in criminal activity, to obtain goods or
services by deception. This usually involves the use of stolen or forged identity documents such as a
passport or driving licence.
• Identity theft (also known as impersonation fraud) is the misappropriation of the identity (such
as the name, date of birth, current address or previous addresses) of another person, without their
knowledge or consent. These identity details are then used to obtain goods and services in that
person’s name.

A person’s identity (and their ability to prove it) is central to almost all commercial activity. Organisations
need to verify that the person applying for credit or investment services is who they say they are and
lives where they claim to live.

The procedures used by organisations to check the information supplied by customers help to detect
and prevent most identity fraud. However, some fraudulent applications are accepted due to the
sophisticated techniques used by the fraudsters.

When opening accounts in banks and other financial organisations, criminals will use data from
legitimate persons to provide information for applications and other purposes which, when checked
against normal credit reference, postal and other databases, will seem to confirm the genuine nature of
the application.

Key to this is accessing what are known as ‘breeder’ documents – those documents that allow those
who possess them to apply for or obtain other documentation and thus build up a profile or ‘history’
that can satisfy basic CDD processes. The information may either be used quickly before the source of
the data is alerted or used, for example, as a facilitator for other identities so as not to alert the source.

Cybercrime is another fast-growing area of crime.

Although there is no single universal definition of cybercrime, law enforcement generally makes a
distinction between two main types of internet-related crime:

• Advanced cybercrime (or high-tech crime) – sophisticated attacks against computer hardware
and software.
• Cyber-enabled crime – many ‘traditional’ crimes have taken a new turn with the advent of the
internet, such as crimes against children, financial crimes and even terrorism.

In the past, cybercrime was committed mainly by individuals or small groups. Today, the authorities are
seeing highly complex cybercriminal networks bring together individuals from across the globe in real
time to commit crimes on an unprecedented scale. New trends in cybercrime are emerging all the time,
with estimated costs to the global economy running to billions of dollars.

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 Regulation and Ethics

Criminal organisations are turning increasingly to the internet to facilitate their activities and maximise
their profit in the shortest time. The crimes themselves are not necessarily new – such as theft, fraud,
illegal gambling, sale of fake medicines – but they are evolving in line with the opportunities presented
online and, therefore, becoming more widespread and damaging.

3. Insider Trading and Market Abuse

3.1 Insider Trading

Learning Objective
8.3.1 Know the offences that constitute insider trading and market abuse and the instruments
covered

When directors or employees of a listed company buy or sell shares in that company, there is a possibility
that they are committing a criminal act – insider dealing.

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For example, a director may be buying shares in the knowledge that the company’s last six months of
trade was better than the market expected. The director has the benefit of this information because
they are ‘inside’ the company. In nearly all markets, this would be a criminal offence, punishable by a
fine and/or a jail term.

To find someone guilty of insider dealing it is necessary to define who is deemed to be an insider, what
is deemed to be inside information and the situations that give rise to the offence.

Inside information is information that relates to particular securities or a particular issuer of securities
(and not to securities or securities issuers generally) and:

• is specific or precise
• has not been made public, and
• if it were made public, would be likely to have a significant effect on the price of the securities.

This is generally referred to as unpublished price-sensitive information, and the securities are referred to
as price-affected securities. The information becomes public when it is published.

Information can be treated as public even though it may be acquired by persons only exercising
diligence or expertise (for example, by careful analysis of published accounts, or by scouring a library).
A person has price-sensitive information as an insider if they know that it is inside information from an
inside source. The person may have:

1. gained the information through being a director, employee or shareholder of an issuer of securities
2. gained access to the information by virtue of their employment, office or profession (for example,
the auditors to the company), or
3. sourced the information from (1) or (2), either directly or indirectly.

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Insider trading takes place when an insider acquires, or disposes of, price-affected securities while in
possession of unpublished price-sensitive information. It also occurs if they encourage another person
to deal in price-affected securities, or to disclose the information to another person (other than in the
proper performance of employment).

The instruments covered by the insider trading rules are usually broadly described as ‘securities’, which
include:

• shares
• bonds (issued by a company or a public sector body)
• warrants
• depositary receipts
• options (to acquire or dispose of securities)
• futures (to acquire or dispose of securities), and
• contracts for difference (based on securities, interest rates or share indices).

Note that the definition of securities does not normally embrace commodities and derivatives on
commodities (such as options and futures on agricultural products, metals or energy products), or units/
shares in open-ended collective investment schemes.

3.2 Market Abuse

Market abuse may arise in circumstances where financial investors have been unreasonably
disadvantaged, directly or indirectly, by others who behave unlawfully. Certain types of behaviour, such
as insider dealing and market manipulation, can amount to market abuse.

Market abuse is a civil offence and can be subject to fines and sanctions by the regulator. Insider dealing
and market manipulation may also be a criminal offence and offences are prosecuted in the courts.

As an example, UK and European regulation specifically prohibits three types of behaviour that may
lead to market abuse, subject to certain exemptions, as shown below.

• Insider dealing arises when a person in possession of inside information uses

it to deal, to attempt to deal, or to recommend or induce another to do so.
• Dealing includes acquiring or disposing of financial instruments to which the
inside information relates, as well as to cancelling or amending an order that
was made before having inside information in relation to that instrument.
Insider dealing
• A person using the recommendation or inducement will also be insider
dealing where they know, or ought to know, that the recommendation or
inducement is based on inside information.
• In the UK, the regulator judges what a reasonable person knows, or ought to
know, in such circumstances.

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 Regulation and Ethics

• The general disclosure obligation requires issuers to inform the public as soon
as possible about inside information which directly concerns them. Where
their securities are admitted to trading on a regulated market, disclosure
must also be made to the officially appointed central storage mechanism.
Public
• There is an obligation to prepare and maintain insider lists of any person with
disclosure
access to inside information.
requirements
• Directors and senior executives (and their closely associated persons) who
have regular access to inside information must notify both the issuer and the
regulator of every account transaction relating to the issuer’s shares, debt
instruments, derivatives or other linked financial instruments.

• Market manipulation is committed if a person carries out specified activities

or behaviours which include:
• giving false or misleading signals about the supply of, demand for or
price of a financial instrument
• using fictitious devices or other deception or contrivance that is likely
to affect the price of financial instruments
• disseminating information which gives, or is likely to give, false
Market
or misleading signals as to supply, demand or price of financial
manipulation
instruments; or secures, or is likely to secure, their price at an abnormal
or artificial level, including circulating rumours knowing the information

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was false or misleading, or
• certain other behaviours including collaborating to secure a dominant
position over the supply or demand for a financial instrument, or
creating other unfair trading conditions including by algorithmic and
high-frequency trading.

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 4. Integrity and Ethics in Professional Practice

Learning Objective
8.1.4 Understand the key principles of professional integrity and ethical behaviour in financial
services

We are all faced with ethical choices on a regular basis, and doing the right thing is usually obvious. Yet
there have been many situations in the news over the years in which seemingly rational people have
behaved unethically.

Despite the relationship between the two, ethics should not be seen as a subset of regulation, but as an
important topic in its own right.

Many firms and individuals maintain the highest standards without feeling the need for a plethora of
formal policies and procedures documenting conformity with accepted ethical standards. Nevertheless,
it cannot be assumed that ethical awareness will be absorbed through a sort of process of osmosis.
Accordingly, if we are to achieve the highest standards of ethical behaviour in our industry, and in
industry more generally, it is sensible to consider how we can create a sense of ethical awareness.

If we accept that ethics is about both thinking and doing the right thing, then we should seek first
of all to instil the type of thinking which causes us, as a matter of habit, to reflect upon what we are
considering doing, or what we may be asked to do, before we carry it out.

There will often be situations, particularly at work, when we are faced with a decision, when it is not
immediately obvious whether what we are being asked to do is actually right.

A simple checklist will help to decide. Is it:

• Open – is everyone whom your action or decision affects fully aware of it, or will they be made aware
of it?
• Honest – does it comply with applicable law or regulation?
• Transparent – is it clear to all parties involved what is happening/will happen?
• Fair – is the transaction or decision fair to everyone involved in it or affected by it?

A simple and often quoted test is whether you would be happy to appear in the media in connection
with, or in justification of, the transaction or decision.

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 Regulation and Ethics

4.1 Codes of Ethics, Codes of Conduct, and Regulation

Learning Objective
8.1.3 Know the Chartered Institute for Securities & Investment (CISI) Code of Conduct

For any industry in which trust is a central feature, demonstrable standards of practice and the means
to enforce them are a key requirement. Hence the proliferation of professional bodies in the fields of
health and wealth – areas in which consumers are more sensitive to performance and have higher
expectations than in many other fields.

Within financial services, we have a structure where, in most countries, detailed and prescriptive
regulation is imposed by regulatory bodies (see section 1.2).

Nevertheless, professional bodies operating in the field of financial services have developed codes of
conduct for their members, and the following table indicates the areas of responsibility that a sample of
these cover.

The Chartered Institute for Securities & Investment (CISI) already has in place its own code of conduct.
Membership of the CISI requires members to meet the standards set out within the Institute’s principles.

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These words are from the introduction:

‘Professionals within the securities and investment industry owe important duties to their clients, the
market, the industry and society at large. Where these duties are set out in law, or in regulation, the
professional must always comply with the requirements in an open and transparent manner.

Membership of the Chartered Institute for Securities & Investment requires members to meet the
standards set out within the Institute’s Principles. These Principles impose an obligation on members
to act in a way beyond mere compliance.’

They set out clearly the expectations upon members of the industry ‘to act in a way beyond mere
compliance’. In other words, we must understand the obligation upon us to act with integrity in all
aspects of our work and our professional relationships.

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 Principles Stakeholders
Self, Clients,
Regulators,
Personal Accountability – to strive to uphold the highest levels of personal
Colleagues,
and professional standards at all times, acting with integrity, honesty, due skill,
Market
care and diligence to avoid any acts, either in person, in a remote working
Participants,
environment or digitally which may damage the reputation of your organisation,
Firm,
your professional body or the financial services profession.
Profession,
Society
Client Focus – to put the interests of clients and customers first by treating them
fairly, being a good steward of their interests, never seeking personal advantage
Clients
from confidential information received and utilising client data only for a defined
purpose.
Conflict of Interest – being alert to and actively manage fairly and effectively
Clients,
any personal or other conflicts of interest, obeying legislation and complying
Market
with regulations to the best of your ability, ensuring you are open and
Participants,
cooperative with all your regulators, challenging and reporting unlawful or
Regulators
unethical behaviour.
Respect for Market Participants – to treat all counterparties and business
Clients,
partners with respect, to observe proper standards of market integrity, good
Market
practice, conduct and confidentiality required to maintain the highest level of
Participants
mutual trust.
Professional Development – to strive continually for professional excellence, Profession,
committing to continuous professional development (CPD) and promoting and Clients,
supporting the development of others. Colleagues
Aware of Capabilities – to decline to act on any matter about which you are not Clients,
competent or qualified unless you have access to such advice or assistance to Profession,
carry out the work in a professional manner, taking into account the nature of the Market
individual mandates given by your customers and counterparties. Participants
Society,
Colleagues,
Clients,
Respect Others and the Environment – to treat everyone fairly and with Regulators,
respect, supporting opportunity for all, embracing diversity and inclusion and Market
ensuring that the environmental impact of your work is considered. Participants,
Profession,
Professional
Body
Speak Up & Listen Up – to be active in speaking up and encouraging others to
Society,
do so by listening up, promoting a safe environment for all and recognising the
Colleagues
responsibilities you have to the communities in which you operate.

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End of Chapter Questions

Think of an answer for each question and refer to the appropriate section for confirmation.

1. What was the International Organization for Securities Commissions (IOSCO) set up to facilitate?
Answer Reference: Section 1.1

2. List three common aims of financial services regulators globally.

Answer Reference: Section 1.2

3. What are the three stages of money laundering?

Answer Reference: Section 2.1.1

4. What is meant by the term ‘inside information’?

Answer Reference: Section 3.1

5. What types of securities do the insider dealing rules apply to?

Answer Reference: Section 3.1

6. What types of behaviour might lead to a charge of market abuse?

Answer Reference: Section 3.2

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